Investigation of the Factors Affecting Financial Instability in Developing Countries: The SGMM Approach

Maintaining financial stability has always been one of the most important economic aims. In order to achieve this goal, the factors affecting the financial stability must be identified and analyzed. Most of the researchers have examined the financial stability from the perspective of price stability and policies of Central Bank and they have considered it as a necessity for economic growth. The literature related to the financial stability show the effect of variables like financial development and financial liberalization on the financial instability. However, some conflicting results have been reported about the direction of this impact. Accordingly, the purpose of this study is to investigate the effect of various factors on the financial instability with an emphasis on the variables of the financial development and financial liberalization in developing countries. The financial instability index has been calculated based on a Principal Component Analysis (PCA) approach and annual observations from 2005 to 2019 have been extracted. The research model is estimated using the System Generalized Method of Moments (SGMM). In contrast with public beliefs, the results indicate that the financial development in developing countries has a positive effect on the financial instability and exacerbates it due to the lack of correspondence between the goals of policymakers and the realities of financial markets in these countries. Moreover, the impact of the financial liberalization on the financial instability in the countries which were under consideration has been positive and shows that following the fiscal policies implemented in the countries with developed financial markets regarding the financial liberalization is not working in developing countries. Thus, financial decision-makers in these countries must adopt stabilization policies in accordance with the characteristics of their financial markets. In addition, the results of this study confirm the negative impact of the government size on financial stability in developing countries, emphasizing the reduction of the government presence and the development of private sector in such markets.